5 Things You Need To Know About A Stock Market Correction

stock decline2013 was a great year for the U.S. stock market.

And you know the saying about good things.  They all come to an end.

But will that be the case in 2014? Here’s five things you need to know about market corrections for 2014.

1).  First of all, what is a correction?

A correction is just a genteel way of saying that stock prices are pulling back from current levels.  For example, a 10% correction from today’s prices would signal a drop from 16,373 on the Dow Jones Industrial Average to 14,735.

The term “correction” implies that the stock market maybe got a little bit ahead of itself, and needs a moment to “correct” and retreat to fairer (e.g. cheaper) valuation levels.

By the way, while a 5% drop can be a “dip,” a “pause” or maybe a little “pullback,” it usually takes a 10% or greater drop to be a “correction.” Go figure.

2).  Will there be a correction in 2014?

Based on nothing other than recent history, it’s fair to say there will be a 5% or 10% pullback in 2014.

Stock analysts at Goldman Sachs estimated back in November that there is “a 67% probability of a 10% drawdown at some point in 2014.”  That same statistic was dusted off and trotted out on CNBC the other day.  Do these guys know something you don’t?

Not really. It’s just statistics.  It’s like saying there’s a 67% probability of rain in South Florida within the next year. As any teenager would say, “duh!”

Looking at stock market behavior since 1900, it turns out that we average a 5% decline (or “correction”) about 3 times per year on average. Prices take about 1 1/2 months to fall that full 5%.

Declines of 10% or more happen about once per year on average, with prices falling for almost 4 months.

A 15% decline? It happens on average every 2 years.  Prices keep adjusting lower for about 7 months.

A 20% correction is less frequent (fortunately!), occurring only once every 3 1/2 years on average. Prices decline for amost a full year.

So it’s fair to say that a correction is not a question of “if.”  It’s a question of “when.”

3).  But can’t we predict when it will happen?

Researchers at American Funds have studied market behavior over the last century. Their conclusion? “It’s easy to look back today and say with hindsight that the stock market was overvalued at a particular time and due for a decline. But no one has been able to accurately predict market declines on a consistent basis.”

Trying to time the market is a fool’s errand. One client recently asked us if she should stay out of the market until prices are lower. Unfortunately, we have no way of knowing when that moment might be.  Prices could drop in two days, two months or two years, or perhaps even never. We think there are better ways to control market risk – such as proper asset allocation, diversification, dollar cost averaging, and liability management – that don’t compromise your ability to capture long-term growth.

4). What should I do if and when prices do correct?

In most cases, the right thing to do is “nothing.”

Bob Doll, chief equity strategist at Nuveen Asset Management and long-time market forecaster, says he sees a pullback coming sometime this year.

He recommends using “pullbacks as buying opportunities as most (economic) fundamentals continue to improve.”

If you are fully invested, stay that way. The worst thing you can do is sell when prices are lower, only to buy back when they go back up again.

5).  Yes, we probably are overdue.

It’s been over 800 days since a 10% correction (the last one was in late 2011). So if prices do correct, don’t panic.

“Stock market corrections are an inevitable part of investing,” say researchers at American Funds. By accepting the normal up-and-down risks of the stock market, you get a ticket to participate in the long-term gains that only the stock market has been able to generate.

And here’s a final incentive to stay the course. Most economists see the economy picking up serious steam in the second half of the year. You want to be well-positioned in your portfolio before that time so you can capture the upward momentum if that happens.

About Mari Adam

Mari Adam, Certified Financial Planner™ and President of Adam Financial Associates Inc, has been helping individuals and families chart their financial futures for over twenty-five years. Have a question about your financial situation? Ask Mari!

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